This article first appeared in The Edge Malaysia Weekly on September 23, 2019 - September 29, 2019

GEOPOLITICAL tensions in the Middle East escalated last Saturday, after coordinated drone strikes on two oil facilities in Saudi Arabia halted almost half of the kingdom’s oil production. The Saudis and the US accused Iran of carrying out the attacks.

In any event, market observers warned that a full-blown conflict between regional rivals Saudi Arabia and Iran will have huge repercussions across the globe. Saudi Arabia — the world’s largest crude oil exporter — and Iran produce around 18% of global petroleum output.

While it is unclear whether the attacks were precursor to something more sinister in the volatile region, developments in the Middle East will be closely watched by Putrajaya due to the impact on crude oil prices.

Contrary to popular belief, the higher crude oil price this time around may not lead to better economic growth for Malaysia, or an improvement in the fiscal budget. This is because the higher prices are a result of geopolitical tensions and not from sustainable demand.

Economists contacted by The Edge agree that while Malaysia should benefit from increased crude oil prices, already sluggish exports — a result of the US-China trade tensions — will be further dampened by a slowing global economy if oil prices stay elevated due to geopolitical pressures.

“Permanent oil shocks would be detrimental to the current stages of the global economy, trade and business cycle, which has succumbed to the prolonged trade hostilities,” says Lee Heng Guie, an economist and executive director at the Socio-Economic Research Centre (SERC).

“Higher oil prices could lead to increasing fuel prices, which would put more pressure on a slowing global economy that is already coping with a weakening manufacturing sector and trade as well as moderating economic growth or even recessionary risk in some advanced economies,” he adds.

As Malaysia is a trade-dependent economy, a disruption in the world economy caused by a prolonged geopolitical crisis in a major oil producing region will affect the country’s exports growth and economic development.

Therefore, it was a relief when Saudi Arabia managed to restore 70% of the halted oil production by last Tuesday. After a knee-jerk reaction last Monday when Brent crude oil price jumped almost 14% following the attacks, the benchmark price moderated to about US$64 per barrel (bbl) two days later.

Although crude oil prices returned to pre-attack levels, economists say the hostilities have led to traders pricing in the risk of further attacks on oil facilities and transport in the Middle East.

Julia Goh, a senior economist and senior vice-president of global economics and markets research at United Overseas Bank (Malaysia) Bhd, says the market has been under-pricing geopolitical risk, but now that risk premium has been loaded back, it has pushed Brent crude prices towards US$70/bbl.

“Geopolitical risk premium is back in full force and near-term supply uncertainties are likely to underpin Brent closer to US$70/bbl. For now, we refrain from adjusting our Brent crude oil forecast and await more clarity on how quickly Saudi Arabia can restore the lost production,” she told The Edge last Tuesday.

She adds that UOB Malaysia will reassess its Brent forecast should prices escalate on the back of damage to Saudi Aramco’s oil facilities leading to a prolonged outage. The bank’s Brent trading target is between US$60 and US$70/bbl.

The Middle Eastern region has been especially volatile the last couple of years, starting with the US’ withdrawal from the Iranian nuclear deal in May last year, followed by the US’ economic sanctions on Iran six month later.

In the past months, several commercial ships near the Strait of Hormuz were attacked by unknown aggressors, prompting the US to deploy more military assets and troops to the Persian Gulf. Oil and petroleum tankers in the region were also seized in a tit-for-tat conflict between the Iranians and the British.

The Sept 14 attacks on Saudi Arabia’s oil refinery in Abqaiq and Khurais, which the US has pinned on Iran, increased the tensions. Houthi rebels in Yemen, backed by Tehran, have claimed responsibility for the attacks.

Without GST, Malaysia depends more on petroleum revenue

Higher crude oil prices will help to close the gap in the budget as the government had used a US$72/bbl price estimate in Budget 2019, whereas prior to the Saudi oil facilities attacks, Brent crude oil prices had averaged to US$66/bbl.

Having scrapped the Goods and Services Tax (GST) last year, the Pakatan Harapan (PH) administration is now more dependent on the petroleum sector for its annual budget, compared with the years following the implementation of the consumption tax in 2014.

In 2013, the income from petroleum sources contributed 31.2% to the federal government’s total income. The implementation of GST had reduced petroleum dependency to 15.7% in 2017.

As GST was only in place until June,  before being replaced by the Sales and Services Tax (SST) in 2018, income contribution from petroleum sources rose to 21.7% of total income, and will increase to about 30.9% this year.

The PH government also dipped into Petronas’ kitty when it requested a special dividend of RM30 billion to cover outstanding GST payments and income tax refunds. In total, the national oil company contributed RM64 billion in dividends for its financial year ended Dec 31, 2018.

While there has yet to be any news on whether the government plans to reduce the budget’s reliance on petroleum, Dr Afzanizam Abdul Rashid, chief economist at Bank Islam Malaysia Bhd, says the question ought to be how the government intends to spend the revenue should oil prices remain elevated.

“Should they spend on development or subsidies? Development spending has a long-term impact, especially on capacity building, while subsidies or transfers are short-term remedies that are also important for the immediate term,” Afzanizam tells The Edge via email last Tuesday, adding that it could boil down to the deficit target in these uncertain times.

Currently, the government has kept the price of RON95 petrol at RM2.08 per litre, which is 15 sen lower than the market price, according to the Ministry of Finance’s automatic price mechanism.

At RM2.08, the subsidy amounts to RM53.55 million a week, but Prime Minister Tun Dr Mahathir Mohamad has given an undertaking that the subsidy will remain even if oil prices shoot up. However, Putrajaya is still looking at a system to transfer fuel subsidies directly to those who qualify.

For Ali Salman, CEO of Institute for Democracy and Economic Affairs (IDEAS), the “unearned revenue” from higher petroleum prices are a double-edged sword given the potential impact on sound economic policies and reforms.

“A temporal shift in global supply can provide a transitory space for the government to earn more revenue, but at the same time, it may be forced to pay higher subsidies. While the government may undertake empirical work to examine the net quantitative results of this shock, in principle, providing a blanket subsidy on oil consumption is a bad idea.

“Similarly, the over-reliance on dividends from Petroliam Nasional Bhd as the government has done this year, signals a lack of seriousness about taxation. Therefore, while this incident can bring some windfall gains, it should not be at the cost of the government’s commitment to institutional reforms,” says Ali in an email response.

Impact of the production cut less than expected

The attacks on Saudi’s oil facilities have cut global oil supply by 5%, but Aramco’s prompt action has restored production and reduced the threat of a prolonged supply disruption. The global oil market is also no longer as dependent on supplies from the Middle East as it has other sources, including Russia and the Americas.

According to Dr Renato Lima de Oliveira, assistant professor of management at Asia School of Business and a fellow at IDEAS, the oil market today is very different from 10 to 15 years ago.

From more than US$100/bbl between 2011 and 2014, oil prices plunged to US$28.79/bbl in January 2016 due to the oversupply owing to the US’ shale gas revolution. Oil prices have never fully recovered since.

“When you sum up the total production of oil and gas, the growth in the US has been more significant. Last year, the US produced 31.7 million barrels of oil equivalent per day (mboe/d). In contrast, Saudi Arabia had 13.6 mboe/d.

“Granted, about 40% of the US’ natural gas and crude oil production is still very important for transport. But 10 years ago, the US oil and gas production was 17.9 mboe/d. Therefore, in 10 years, the US has added 13.8 mboe/d to its oil and gas capacity — one Saudi Arabia of energy!” says de Oliveira.

The US shale production has made it a major energy powerhouse, and thus it is less interested in protecting Saudi’s oilfields at any price, he tells The Edge via text message.

As there has been a global energy revolution with growing production from the US and other countries such as Brazil, coupled with impressive competitive gains from renewable sources, a crisis in the oil market now would be less severe than it would have been 10 years ago, de Oliveira says.

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